What has been the fallout of electricity deregulation fiasco in California?

It has become increasingly apparent that the crisis which occurred in California in 2001 was the result of flawed legislation which allowed unscrupulous companies in the energy industry to manipulate the cost of electricity in a manner which bore little relation to the actual real supply or demand for this product. The most glaring example of this has been the recently discovered tapes of Enron employees poking fun at "ripping off" California consumers during the height of the crisis. The major flaw in the legislative scheme appears to have been the creation of a "spot market" for electricity. Electricity is not like other commodities in that there must be a constant sufficient supply to meet total demand, unlike other commodities in which temporary scarcities will have little economic effect. Therefore, if supply was manipulated by surprise, a significantly inflated price could be extracted from purchasers in a short term market. The fallout from this economic disaster is still in progress. The California government was required to purchase electricity under long term contracts at what clearly were inflated prices. The state has only had limited success in obtaining relief from the size of these contractual burdens. One organization which has studied the problem has concluded that the total cost to California consumers and taxpayers is $71 billion, an amount which is very close to the yearly state budget. The degree to which wholesale energy companies such as Enron which had contributed substantially to political parties in the 2000 election influenced the political decisions involved is still being investigated. Quite obviously, as in the similarly flawed thrift deregulation, there was a massive transfer of wealth from ordinary consumers to a wealthy group and this transfer had little real economic basis. As in the thrift scandal, the government ended up "bailing out" the industry at a massive cost to taxpayers. California rapidly went from a budget surplus to its most severe economic crisis ever.

How has the electricity industry traditionally been regulated?

The regulation has occurred at both the state and federal level.

In the earliest days, there was no regulation of the electric power industry. Small companies operated small generators in municipal areas and sold power to industries and other users in that area. In 1896, Westinghouse pioneered the use of alternating current to deliver electricity over a long distance from its hydroelectric plant at Niagara Falls. This generating and delivery system was far more efficient and quickly became the national standard. This development quickly led to the formation of large "public utility" companies.

It soon became clear that generation, distribution and sale of electricity was virtually a monopoly. Some municipalities established publicly owned utilities, but most electric power was provided by private companies. (Click to see chart) Although these electric utilities did purchase some electricity, most of the electricity they sold was generated by the company itself. The distribution and sale of electricity to users was clearly a monopoly because it only made sense to have one set of power lines leading to each consumer. Because its monopolistic nature, states quickly established "Public Utility Commissions" (PUCs) to regulate the price of electricity sold to consumers. Under the standard type of regulation, the utility would justify its rates by accounting for the cost of producing, distributing and marketing the electricity and would be entitled to a "fair" rate of return.

As the industry continued to develop, utilities combined into large financial holding companies. In 1935, almost half of the generation of electricity in the country was under the control of three large holding companies. Because of the size, complexity and interstate nature of these trusts, their effective regulation by state public utility commissions became impossible. Not surprisingly, these trusts were accused of manipulating the cost of electricity in an anti-competitive fashion.

The result was the onset of federal regulation of electric power. The Securities and Exchange Commission was provided with authority to require that the interstate holding companies divest their holdings until each became a single consolidated system serving a prescribed geographic area. At the same time, the Federal Power Commission (now the Federal Energy Regulatory Commission) was created for the purpose of regulating the interstate wholesale electricity market.

Under the resulting system, the electric power industry became a group of geographically contained "vertical" monopolies which controlled the generation, distribution and marketing of power in each company's territory. Because they controlled the generation of power using primarily fossil fuels , the existence of this system has discouraged the development of renewable and other innovative energy sources because companies attempting to develop such new technologies did not have access to the country's power system. Moreover, because the profitability of the public utilities depended on increased consumption and thus there was no incentive for the utilities to encourage energy conservation. This deficiency became particularly apparent during the fuel crisis in 1973 and 1974.

In 1978, Congress passed legislation to require utilities to purchase power from companies which generated power using renewable sources or through "cogeneration". In 1992, Congress passed additional legislation which allowed generating companies to be exempt from regulation and have access to the nation's distribution systems at "just and reasonable" rates. This development opened the door to a restructuring of the electric power industry by allowing for market competition among power generators.

Why has deregulation been considered?

The federal legislation which allowed nonutilities the ability to market their power was the first step towards a realization that the electric power industry was not necessarily a natural monopoly at least when it came to generating electricity. Other industries such as the banking industry, the airline industry and the telecommunications industry had successfully underwent deregulation. Many consumers in states with high rates (Click to see map) anticipated that deregulation would improve prices. Moreover, new technologies for generating electricity using modern turbines allow cost effective smaller scale generating systems.

The main argument used to support deregulation is that a freer market promotes efficiency. In a regulated environment, for example, wholesale and retail electricity power prices are calculated based on a utility's costs. If a utility invests in what turns out to be an uneconomical project, it can still add the costs of the investment to the price it charges for electricity. Thus, the risks and economic consequences of a poor investment are passed to the electricity customer.

What are the perceived problems with deregulation?

The price of electricity can be too easily manipulated

One result of deregulation is that many public utilities have formed new holding companies and subsidiaries which only generate power. The top ten companies now generate almost 50% of the nation's power and the top twenty companies generate about 75% of the power. (Click to see chart) This restructuring has been partly the result of the deregulation legislation in some states which have required utilities to divest their generating capability. This "horizontal" domination of the market can lead to the same type of market manipulation that prompted federal regulation legislation in the 1930's.

More importantly, electricity is very different from other commodities because there is no economical way to store it nor is there any way to reduce demand by making less available. This fact significantly helps companies manipulate the market because any shortage of electricity will cripple the entire system. It does not take concerted action by companies to drive up the price. This is especially true in many areas where there are limits to how much electricity can be "imported" from adjacent areas because of the existing limits to transmission capability. It is very costly to construct new transmission lines. Thus the local unregulated electric supplier can raise prices to an artificially high level and the consumers have no choice but to pay for the unreasonably high charge.

Current deregulation does not sufficiently affect how consumers use electricity

In a deregulated marketplace, the price of electricity fluctuates by the season, the weather, and by the time of day. Prices are governed by the amount of available generating capacity and the amount of demand. But consumers are charged just a flat fee for their use of electricity that does not vary with the cost of electricity that they are using. The technology for charging consumers varying prices based upon the time that they use electricity has not yet been developed and is several years away. Thus consumers are not encouraged to use electricity in an economically prudent way. Many economists believe that until there is a way for the demand for electricity to respond to changes in price, there has to be some type of regulatory price cap on the cost of electricity.

Most European countries have an electric power industry characterized by a public/private partnership. Although the economic structure varies from country to country, typically the actual sale of electricity is handled by municipalities and cooperatives and the generation is accomplished by private or semi-private companies. Only in England and Belgium are the systems entirely private. Although there is a general trend toward deregulation, the maximum price of electricity is capped in each country. The residential rates for electricity in Europe are remarkably similar to those in the United States.

How are states "deregulating" electric power?

Several states, most predominantly California, have led the way in enacting legislation to restructure the electric power industry through deregulating electricity production. Although utilities retain the ownership of transmission lines, they no longer control access to them. This responsibility has been transferred to a non-profit organization called an "Independent System Operator" which controls transmission of all electricity in the region. Currently five such "ISOs" are in operation throughout the country. In California and some other states, the utilities were required to divest themselves of power generating assets. In California, utilities were subject to a rate cap until they recovered their "stranded costs" and completed divestment.

In California, a nonprofit "Power Exchange" or "PX" was created as an auction market for the buying and selling of electricity. This feature was discontinued when it was realized that a reliance on "spot market" pricing was contributing to the high cost. Now utilities contract with power suppliers directly and are able to structure contracts which provide more price stability. Under all plans, the costs and profits associated with the transmission, delivery and sale of electricity to consumers remain regulated.

What has happened in California?

Under the legislation, the price of electricity was temporarily fixed at 6.5 cents per killowat hour which was substantially higher than the market price. The utilities were allowed to use the difference to recover "stranded" costs which were costs for equipment which could not be sold to producers. The wholesale price for electricity generation precipitously jumped in the summer of 2000 less than a year after one of the three major utilities (San Diego Gas & Electric) was allowed by the legislation to charge consumers an unregulated price after recovering these stranded costs. The rise in price was unrelated to any increased demand when compared to the previous year. The causes of such a dramatic rise are not completely clear although it is becoming more clear that power companies took advantage of the absence of regulation to close plants for maintenance to create artificial shortages. Indeed, the pattern of plant closures was abnormal when compared to the previous year.

Other studies have indicated that increased demands caused by population growth and a decrease of hydroelectric power capacity in the Pacific Northwest substantially contributed to the problem.

Because they had not recovered stranded costs, the other two major utilities in California, Southern California Edison and Pacific Gas and Electric were required to charge consumers no more than 6.5¢ per kilowatt hour until March 2002. Because this rate had become much lower than the market rate, both utilities began to lose vast sums of money because they had to purchase power at the unregulated market rates. Their requests to raise rates above the legislative cap were refused and Pacific Gas and Electricity declared bankruptcy. Because San Diego Gas & Electric was exempted from the cap, the State government has been purchasing power over 6.5¢ on behalf of San Diego consumers since September 2000. For many months in the fall of 2000 and spring of 2001, the Federal Energy Regulatory Commission and the Bush Administration refused to regulate the wholesale prices despite the requests of California Governor Gray Davis and most members of California's Congressional delegation. Finally in April 2001, the FERC did institute a temporary wholesale price cap formula only after the state began purchasing power under long term contracts. The result has been a form of new regulation. In order to pay for purchases of power, the state has authorized rate increases and the issuance of a $12.5 billion bond measure. Shortly after the negotiation of these contracts, the cost of electricity substantially decreased but the state is locked into long-term contracts which are substantially higher than the present market rate.

What about other states?

Restructuring has not caused the problems that California has experienced, probably because no "spot market" for power was created and long term contracts guarantee a steady electricity supply. In Pennsylvania, many consumers have begun to choose different electricity suppliers and the rates have actually decreased. Pennsylvania, unlike California, did not require their utilities to divest themselves of power generation.